Bank of America Says Housing May Trigger `Correlation Crisis

March 30 (Bloomberg) -- U.S. homebuilders may trigger a ``correlation crisis'' similar to the credit sell off in 2005 when Ford Motor Co. and General Motors Corp. lost their investment-grade credit ratings, according to Bank of America Corp.

The ratings cuts to the automakers triggered losses for banks and hedge funds holding the riskiest parts of collateralized debt obligations, securities that package bonds, loans and credit-default swaps and use the income to pay investors.

An increase in the perceived risk of default by homebuilders such as Dallas-based Centex Corp. and Lennar Corp. in Miami could cause similar losses this year, Bank of America analysts Glen Taksler and Jeffrey Rosenberg wrote in a report today. Construction company profits have plunged since the five- year U.S. housing boom ended a year ago. Rising inventories of unsold homes and reluctance by potential buyers wary of falling prices has stifled sales.

``We see increasing risk signals that remind us of the run- up to the 2005 correlation meltdown,'' the analysts wrote in the report titled ``The Correlation Crisis of 2007?''

CDOs are divided into portions of varying levels of risk and return. The riskiest piece, known as the equity tranche, pays the highest yield and is the first to absorb losses when credit quality deteriorates.

Investors may demand a higher premium for holding the equity tranche related to the benchmark investment-grade credit- default swap index, should the cost of contracts on homebuilders in the index rise, the analysts said.

``We would not be surprised to see a potential dramatic increase in the premiums required by equity tranche holders to hold first-loss risk,'' the analysts wrote. ``A reversal in the current demand for equity tranche protection could send investment-grade index spreads significantly wider.''

Bondholder Protection

Credit-default swaps are designed to protect bondholders against defaults. Buyers of the contracts receive the face value of defaulted debt in return for handing over the bonds or the cash equivalent.

The CDX Series 8 Index of investment-grade credit-default swaps includes homebuilders Centex, Lennar, Toll Brothers Inc. and Pulte Homes Inc. It also includes mortgage-lender Countrywide Home Loans Inc. and mortgage insurer and financial guarantor Radian Group Inc.

Equity Plummets

In May 2005 equity tranches plummeted after Standard & Poor's cut the credit ratings of GM and Ford to junk, driving up the perceived risk of holding their debt and forcing investors to exit the riskiest portions. At the time, the CDX index included four auto-related companies.

The fall in equity value also forced investors to buy more protection on the investment-grade bond index to hedge their positions. That pushed up the cost of protecting against default by roughly 20 basis points, according to Bank of America. A basis point is 0.01 percentage point.

Credit-default swaps based on homebuilder bonds fell yesterday after surging this week to the highest levels since at least October 2004, the earliest date for which prices are available. Contracts tied to the debt of Miami-based Lennar, the nation's largest homebuilder by revenue, fell $7,000 per $10 million to $113,500, according to CMA Datavision.

There is some detractors from the "subprime not a big deal" camp...but it's slow to hit people for some reason that a company like Countrywide, the nation's largest lender, wrote $1.2 trillion in loans last year. Half of those are Alt-A loans and they packaged up a lot of their loans and sold them to Wall St. That's only one lender.